Question

Suppose the DJIA stands at 11,500. You want to set up a long straddle by purchasing 100 calls and an equal number of puts on the index, both of which expire in three months and have a strike of 115. The put price is listed at $1.50 and the call sells for $2.50. a. What will it cost you to set up the straddle, and how much profit (or loss) do you stand to make if the market falls by 650 points by the expiration dates on the options? What if it goes up by 650 points by expiration? What if it stays at 11,500? b. Repeat part a, but this time assume that you set up a short straddle by selling/writing 100 July 115 puts and calls. c. What do you think of the use of option straddles as an investment strategy? What are the risks, and what are the rewards? a. To set up the long straddle, it will cost $ (Round to the nearest dollar. Enter a positive number for the cost.) If the market on the long straddle falls by 650 points by the expiration dates on the options, the profit (or loss) is $ . (Round to the nearest dollar. Enter a positive number for a profit and a negative number for a loss.) If the market goes up by 650 points by the expiration dates on the options, the profit (or loss) is $ . (Round to the nearest dollar. Enter a positive number for a profit and a negative number for a loss.) If the market stays at 11,500 by the expiration dates on the options, the profit (or loss) is $ . (Round to the nearest dollar. Enter a positive number for a profit and a negative number for a loss.) b. Your revenue from setting up the short straddle is $ . (Round to the nearest dollar.) . (Round to the nearest dollar. Enter a positive number for a profit and a If the market on the short straddle falls by 650 points by the expiration dates on the options, the profit (or loss) is $ negative number for a loss.) . (Round to the nearest dollar. Enter a positive number for a profit and a negative number for a If the market goes up by 650 points by the expiration dates on the options, the profit (or loss) is $ loss.) If the market stays at 11,500 by the expiration dates on the options, the profit (or loss) is $ . (Round to the nearest dollar. Enter a positive number for a profit and a negative number for a loss.)

Answer 1

a]

Cost of long straddle = total premium paid

total premium paid = (number of calls * premium per call) + (number of puts * premium per put)

total premium paid = (100 * $2.50) + (100 * $1.50) = $400

To set up the long straddle, it will cost $400

Profit on long straddle = absolute difference between strike price and underlying price at expiration - total premium paid

Profit on long straddle = absolute difference between strike price and underlying price at expiration - total premium paid

If market falls by 650 points, profit on long straddle = 650 - 400 = $250

If market goes up by 650 points, profit on long straddle = 650 - 400 = $250

If market stays at 11500, profit on long straddle = 0 - 400 = -$400

b]

Revenue from short straddle = total premium received

total premium received = (number of calls * premium per call) + (number of puts * premium per put)

total premium received = (100 * $2.50) + (100 * $1.50) = $400

Revenue from setting up the short straddle is $400

Profit on short straddle = total premium received - absolute difference between strike price and underlying price at expiration

If market falls by 650 points, profit on short straddle = 400 - 650 = -$250

If market goes up by 650 points, profit on short straddle = 400 - 650 = -$250

If market stays at 11500, profit on short straddle = 400 - 0 = $400

c]

Straddles are a useful investment strategy. They can be used to profit from your view of the market if they are used correctly, and the market moves as expected.

Long straddle :

• It is best used when you expect the market to make a huge move, but you are uncertain of the direction
• The reward is potentially unlimited, as the options are long options
• The risk is limited to the total premium paid

Short straddle :

• It is best used when you expect the market to stay or near the strike price at expiration
• The reward is limited to the total premium received
• The risk is potentially unlimited as the options are short options